Opinion
Docket No. 1261-74.
1975-11-26
MAYO HOLBROOK AND VERNA HOLBROOK, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
William H. Beck, for the petitioners. Robert P. Ruwe, for the respondent.
William H. Beck, for the petitioners. Robert P. Ruwe, for the respondent.
Held, petitioners are not entitled to a percentage depletion deduction in 1970 with respect to income derived from coal mining under a nonexclusive and nontransferable license which was subject to termination without cause by giving the licensee 10 days' notice.
FEATHERSTON, Judge:
Respondent determined a deficiency of $12,605.40 in petitioners' Federal income tax for 1970. The issues to be decided are: (1) Whether petitioners are entitled to a percentage depletion deduction under sections 611
and 613, with respect to income derived from coal mining operations; and, if so, (2) whether petitioners' gross income as determined for purposes of sections 611 and 613 must be reduced in the amount of certain transportation costs incurred during the year in issue.
All section references are to the Internal Revenue Code of 1954, as in effect during the year in issue, unless otherwise noted.
FINDINGS OF FACT
Petitioners Mayo and Verna Holbrook, husband and wife, were legal residents of Whitesburg, Ky., when their petition was filed. Petitioners filed a joint Federal income tax return for 1970 with the District Director of Internal Revenue, Louisville, Ky.
Petitioner Mayo Holbrook (hereinafter referred to as Holbrook) was engaged in the business of coal mining for a number of years. On March 23, 1967, his wife, petitioner Verna Holbrook (hereinafter Mrs. Holbrook), as licensee, executed a document entitled license No. 145 with the Kentucky River Coal Corp. (hereinafter Kentucky River), as licensor. The document provided in pertinent part:
WITNESSETH: That for and in consideration of the performance by the Licensee of the provisions hereinafter set forth, the Licensor hereby gives and grants to the Licensee the license, right, and permission, at the sole cost and expense of the Licensee, and subject to the provisions hereinafter set out, to mine coal from the No. Whitesburg seam of coal on the following tract of land, to wit:
Lying and being in Letcher County, Kentucky, on the waters of Smoot Creek * * *
The terms of this license are as follows:
1. Licensee will begin work immediately and will prosecute the mining of the coal hereunder with due diligence during the life of this license.
4. Licensor will furnish at its cost all necessary mining engineering, but Licensor shall in no event be responsible for the conduct or manner of mining nor any of the other cost incident thereto, nor for the employing, hiring, firing, controlling or directing any of the employees of Licensee working in said mine or mines, nor any other activity connected with the mining and selling of the said coal.
5. Licensee shall have the right to use so much of the surface and/or mining rights in and on said boundary for the mining of the coal covered hereby as may be vested in Licensor, but such rights shall not be exclusive and Licensor reserves the right to use or grant to others the joint use of said surface and/or mining rights.
6. Licensee agrees to mine all of the mineable and merchantable coal covered hereby in a good and workmanlike manner, and according to the laws of Kentucky and the United States applicable to such mining.
8. Title to the coal covered hereby shall not pass until the same has been reduced to physical possession by Licensee.
10. This license shall continue in force until all of the mineable and merchantable coal covered hereby is mined and paid for unless the same is sooner revoked. This license is revocable at the pleasure of the Licensor, and may be revoked by Licensor at any time, with or without cause, by giving to the Licensee Ten Days written notice in person, or by mail, or by posting the same at any mine portal or opening on the premises. The Licensee may likewise surrender and terminate this license by giving Licensor Ten Days written notice, in person or by certified mail. And in the event of such revocation or termination, if Licensee shall not be in default of any payments hereunder or in default of any of the provisions or agreements herein contained, Licensee may remove within Thirty Days all of its equipment and property on said premises; but if in default, or at the expiration of said Thirty Days, all such equipment and property shall become the absolute property of Licensor without any accountability therefor.
11. This license is personal to the Licensee and is in all respects nontransferrable.
12. This license shall be strictly construed according to its terms and any and all rights not herein specifically given to the Licensee are excepted and reserved to the Licensor.
The agreement also provided for payment of a royalty in the sum of 28 cents per ton of coal mined or a minimum monthly royalty of $300 per month. Pursuant to the terms of the license, Kentucky River provided engineering services for Holbrook's operations designed to ensure that petitioner's mining operations were conducted along a profitable direction. Kentucky River also reserved the right to, and in fact did, make periodic inspections of the mines described in license No. 145 for the purpose of measuring the amount of coal extracted and ensuring that Holbrook was mining in accordance with acceptable practices.
Prior to conducting mining operations in mine No. 145, Holbrook was required by Federal safety laws to improve the roof support in the mines to prevent its collapse. Holbrook expended approximately $4,000 to $5,000 for this purpose, a process which took nearly 4 weeks to complete.
From March 1967 through March 1971, Holbrook successfully mined the property covered by license No. 145. As permitted by the license, petitioner sold the coal to several different purchasers, obtaining the highest possible price. In 1970, Holbrook had gross receipts in the amount of $347,095.62 from these operations. Holbrook paid royalties to Kentucky River in the amount of $16,014.50 during that year. He never paid the minimum royalty because the amount of coal extracted consistently produced a higher royalty. These payments averaged approximately $1,200 to $1,500 per month during 1970.
Most of the improvements and equipment utilized in Holbrook's mining operations with respect to mine No. 145 were movable. Much of that equipment had been used in other mines and had been purchased prior to 1967. Some equipment used in this mine was later used in other mines. One machine utilized in this operation, a ‘joy’ loader, was purchased in 1967 from the former operator of the mine at a cost to Holbrook of approximately $16,000. Holbrook also erected several buildings necessary for the mining operations on the area covered by license No. 145. Some of them were salvageable and others were not.
Holbrook also incurred other deductible expenses in 1970 as a result of the mining operation. Among the items listed as deductions on petitioners' income tax return for that year is an expense for ‘Contract hauling’ in the amount of $52,017.88.
On their 1970 income tax return petitioners deducted $33,108.11 as a depletion allowance with respect to their mining operations under license No. 145. Respondent disallowed that deduction in its entirety. Respondent determined, alternatively, that if petitioners are entitled to a percentage depletion deduction, their gross income from mining should be reduced by the amount expended for contract hauling, $52,017.88. Respondent thus reduced the claimed depletion by $5,201.79.
Since we have concluded that the claimed percentage depletion deduction is not allowable, we do not reach this alternative determination.
OPINION
Section 611(a) provides that in the case of mines there shall be permitted as a deduction in computing taxable income a reasonable allowance for depletion according to the peculiar conditions of each case. Section 613 provides that the depletion allowance in the case of coal shall be 10 percent of the gross income from the property (defined as the gross income from mining, sec. 613(c)), excluding amounts paid as royalties by the taxpayer in respect of the property. The theory of the deduction is that ‘extraction of minerals gradually exhausts the capital investment in the mineral deposit,‘ and the allowance ‘is designed to permit a recoupment of the owner's capital investment in the minerals so that when the minerals are exhausted, the owner's capital is unimpaired,‘ Commissioner v. Southwest Expl. Co., 350 U.S. 308, 312 (1956). See Parsons v. Smith, 359 U.S. 215, 220 (1959).
The touchstone for determining eligibility for the depletion allowance is the ownership of an ‘economic interest’ in the minerals in place. The rule for determining who has an ‘economic interest’ in the minerals in place has been crystallized in section 1.611-1(b)(1), Income Tax Regs., as follows:
Annual depletion deductions are allowed only to the owner of an economic interest in mineral deposits * * * . An economic interest is possessed in every case in which the taxpayer has acquired by investment any interest in mineral in place * * * and secures, by any form of legal relationship, income derived from the extraction of the mineral * * * to which he must look for a return of his capital. * * * A person who has no capital investment in the mineral deposit * * * does not possess an economic interest merely because through a contractual relation he possesses a mere economic or pecuniary advantage derived from production. * * *
This regulation boils down to two tests for identifying an economic interest: (1) A capital investment in the mineral in place, and (2) a return on the investment which is realized solely from the extraction of the mineral. There must exist some element of ‘ownership’ in the mineral deposit ‘in place’ and a right to share in the income from its production. The mineral deposit ‘in place’ must be reservoir of the taxpayer's capital investment, and that reservoir must be depleted through production. Lynch v. Alworth Stephens Co., 267 U.S. 364, 370-371 (1925); Kohinoor Coal Co. v. Commissioner, 171 F.2d 880, 883 (3d Cir. 1948), affg, a Memorandum Opinion of this Court, cert. denied 337 U.S. 924(1949). The application of these principles ‘depends upon the totality of the facts of each case.’ Ramey v. Commissioner, 398 F.2d 478, 479 (6th Cir. 1968), affg. 47 T.C. 363(1967).
We do not think petitioners ‘acquired by investment any interest in mineral in place’ within the meaning of this regulation. The only right petitioners acquired was a nonexclusive and nontransferable license, interest in the coal in place but, under the license, retained ‘the right to use or grant to others the joint use’ of the surface and/or mining rights.' Kentucky River could terminate the license at its ‘pleasure’ by ‘giving to the Licensee (i.e., petitioners) Ten Days written notice in person, or by mail, or by posting the same at any mine portal or opening on the premises.’
Where a license, such as the one granted petitioners by Kentucky River, permitting a licensee to mine coal is nontransferable, is nonexclusive, and is terminable at will on short notice, the owner has given up none of his capital interest in the coal in place. The owner, without cause, can stop the licensee's operations at any time he wishes to do so. He can mine the coal himself. He can permit others to mine coal from the same property, with or without a termination of the licensee's mining rights. The owner thus retains complete control over, and ownership of, the coal in place and the price he will require others to pay for the privilege of mining it. Such a license does not convey ‘any interest’ in the coal ‘in place’ but, in the words of the regulation, transfers ‘a mere economic or pecuniary advantage’ to be ‘derived from production.’ Whitmer v. Commissioner, 443 F.2d 170, 172 (3d Cir. 1971), affg. a Memorandum Opinion of this Court; United States v. Wade, 381 F.2d 345, 350-351 (5th Cir. 1967); United States v. Stallard, 273 F.2d 847, 851 (4th Cir. 1959); Charles P. Mullins, 48 T.C. 571, 582 (1967); see generally Paragon Coal Co. v. Commissioner, 380 U.S. 624, 633-634(1965); Parsons v. Smith, 359 U.S. 215, 224 (1959).
Moreover, petitioners did not make any ‘investment’ in the minerals ‘in place.’ The only investment petitioners had in the mining operation was their equipment and roof supports and all, or nearly all, of these items were movable.
That investment was recoverable and was recovered through depreciation, and all the rest of petitioners' outlays were recovered through current expense deductions. See Paragon Coal Co. v. Commissioner, supra, Parsons v. Smith, supra; Lesta Ramey, 47 T.C. at 373-374. The nonexclusive character of the license and its terminability by either party on short notice without cause refutes any contention that petitioners' obligations under the license constituted a capital investment for which an economic interest was acquired.
On brief petitioners assert they paid $16,000 to a Mr. Proffit for the purchase of the Kentucky River license. However, Holbrook first testified that he paid the prior ‘owner’ of the mine $16,000 for a ‘joy’ loader, and on their joint income tax return for 1970 petitioners show two items acquired in 1967 (when they were granted license No. 145) in the respective amounts of $15,494.86 and $2,300. In response to later leading questions, Holbrook gave testimony which could be interpreted to mean that he paid $16,000 for license, but at one point Holbrook interrupted a colloquy of counsel to say the payment was for the ‘lease and the loader both.’ No documentation of the transaction was introduced. The license here in issue was granted by Kentucky River to Verna T. Holbrook without any reference to a prior owner, and it expressly provides that it ‘is personal to the Licensee and is in all respects non-transferrable.’ We are not satisfied petitioners paid anything for the license as such.
It was true that the coal, after it was mined, belonged to petitioners and that they were free to sell it to others at any price they could negotiate. But they had no interest in the coal ‘in place.’ Until the coal was mined and reduced to petitioners' possession, it belonged to Kentucky River. For each ton they mined, petitioners paid Kentucky River an agreed price, referred to in the license agreement as a royalty, and to secure the payment of that price Kentucky River reserved a lien on all coal mined and not previously sold and upon all equipment and improvements placed upon the property. In no sense do these provisions confer on petitioners an economic interest in the coal in place.
The facts in Winters Coal Co. v. Commissioner, 496 F.2d 995 (5th Cir. 1974), revg. 57 T.C. 249 (1971), relied upon by petitioners, are distinguishable. In that case, the court held that a lease of coal lands, which was terminable on 30 days' notice, conveyed an economic interest in the coal in place, but the lease required the lessee to obtain rights from the owner of the surface rights before the lease could become effective. Citing Commissioner v. Southwest Expl. Co., supra, the court emphasized (496 F.2d at 998) that the surface-rights-ownership requirement was crucial to its holding. Indeed, the opinion indicates that, absent that requirement, the majority would have concluded that the taxpayer did not have an economic interest in the minerals in place because of the short term of the lease and the cancellation clause.
In the In the instant case, the ‘Licensor reserves the right to use or grant to others the joint use’ of the surface rights.
Also distinguishable on its facts is Bakertown Coal Co. v. United States, 202 Ct.Cl. 842, 485 F.2d 633 (1973), where the taxpayer had a valid mineral lease which, though subject to termination, granted the taxpayer exclusive rights which were fully effective until terminated.
We conclude petitioners are not entitled to the disputed depletion allowance.
Decision will be entered for the respondent.